Slashing 401(k) limits to fund budget is like 'robbing Peter to pay Paul'

The Trump administration and Congress have been mulling a reduction in the 401(k) tax-free contribution limits as they work on a tax plan. Currently, the employer-based plans allow most employees to put away up to $18,000, deferring taxes until a withdrawal is made upon retirement.

The 401(k) may be changed because the Trump administration is looking for ways to drum up revenue to pay for its tax reform plan, which includes significant cuts, while not adding to the national debt, an issue dear to many conservatives.

The tax-free nature of a 401(k) is set to cost the government $583 billion in lost revenue between 2016 and 2020. A significant cut to the program would bridge most of that gap.

However, it’s not that simple. The 401(k) simply defers taxes, it doesn’t exempt them. According to the Tax Foundation, a nonpartisan think tank, this half-trillion figure “does not represent taxes that will never be paid. Instead, it represents taxes that will be paid at a future time, when individuals retire.”

“The revenue will have to be found in the future,” Olivia Mitchell, a professor at the Wharton School and executive director of the Pension Research Council, told Yahoo Finance. “It’s robbing Peter to pay Paul.”

Slashing 401(k) makes revenue for the short term, but not the long

The Tax Foundation’s analysis noted that this “Rothification,” as they call it, — a Roth IRA uses post-tax earnings but does not tax withdrawals — “mainly alters the timing of collecting taxes, and using it to raise revenue.”

“It’s essentially an accounting gimmick,” said Mitchell. “We do need tax reform and pay fors, but this one doesn’t bring about the kind of long-term tax reform that we need.”

The Tax Foundation and the Committee for a Responsible Federal Budget’s Marc Goldwein also called it a “budgetary gimmick.”

“Roths are a worse deal for the federal government — probably more revenue is lost,” he told Yahoo Finance. “So if anything, switching from traditional tax-deferred plans to Roth IRAs is probably a long-term loss.”

Even if it doesn’t help the budget, it could still be smart

Goldwein notes everything depends on the policy. From a budget standpoint, cutting 401(k)’s tax-exempt status could be revenue neutral to negative, but it could be good from a policy standpoint — getting people to save. In comments at the Yahoo Finance All Markets Summit, chief GOP tax author Rep. Kevin Brady (R-TX) alluded to creating policy that encourages savings beyond current 401(k) participation.

If Congress does elect to reduce 401(k) limits and put forth policy that encourages people to save through other vehicles like Roth IRAs, it’s important to know it’s not going to last, Goldwein noted. “The right thing to do would be to set it aside, if you know money is going to go away,” he said.

Withdrawals from Roth IRAs may not be tax-free forever

A shift to Roths from traditional vehicles may present a further fiscal problem in the future. Mitchell believes that taxes will have to rise in the future, potentially erasing Roths’s tax-free withdrawal.

“With population aging and longer lifetimes we’re not going to be able to keep the promise to have Roths not be taxed in retirement,” she said. “I think it’s going to get more difficult to protect.”

The mixed messages from President Donald Trump shows the political danger of touching retirement savings. After Trump tweeted that “There will be NO change to your 401(k)” on Oct. 23, Trump then told reporters two days later, “Well, maybe it is [on the table], and maybe we’ll use it as negotiating.”

Politicians from both parties have tried to scale back the 401(k) system. Former President Barack Obama proposed a cap on 401(k) balances of $3.4 million in 2015. As this year’s Nobel Laureate Richard Thaler noted in a tweet, “reducing the limit on 401(k) contributions is massively progressive.”

So while politicians may not decide to directly tax Roth IRA withdrawals, they may find a way around it.

“Even if they don’t tax it directly, they’ll do it indirectly,” said MItchell, who cited means testing for other social programs as a way to tax. “if you have more money, you pay more for benefits. So it’s already there.”